Your divorce involves a significant amount of asset transfers. New York state uses the doctrine of equitable distribution to determine how assets will be shared in a divorce. Property is distributed in a way that is fair but not necessarily an equal split. When property is distributed in divorce, there are significant tax ramifications that must be planned for and considered.
Taxation of Distributed Property
Your divorce judgment will distribute all of the marital property and indicate how the items are divided between each spouse. As a result of this, items that were jointly owned during the marriage must be transferred to one spouse's name. Some assets may have been held in one spouse's name but were actually marital property. If the court distributes them to the other spouse, they will also need to be transferred to the other spouse's name.
These transfers do not trigger a taxable loss or a gain in the eyes of the IRS as long as they meet some requirements. There are no tax consequences as long as the transfer happens:
- Within one year of the cessation of the marriage, or
- Not more than six years after the date of the cessation of the marriage if it is pursuant to a divorce or separation instrument.
These timelines are important to keep in mind because a transfer that occurs outside of those boundaries will become a taxable event in the eyes of the IRS.
Capital Gains Exclusions
Divorce is about more than just distribution of assets. It is also about planning and timing. When you take certain actions can have significant tax consequences. The sale of your residence is an important example. The IRS permits a $250,000 per person or a $500,000 per couple capital gains exclusion on the profits from the sale of a residence.
If your home is transferred to you as part of your divorce and you then sell the home, you will only be entitled to claim $250,000 as a capital gains exclusion. However, if you and your spouse sell the home before the divorce, you are entitled to a $500,000 exclusion, which is a significant savings. Carefully planning to take advantage of capital gains exclusions is an important part of divorce negotiation.
Transfer of Basis in a Divorce
The transfer of an asset as part of a divorce is not considered a sale in the eyes of the IRS. Therefore, the recipient of the asset takes on the transferor's adjusted tax basis in the asset. If you and your spouse have an adjusted basis of $6 million for a piece of real estate and that property is distributed to you in the divorce, your adjusted basis will be $6 million.
Any gain or loss on the property is deferred until the recipient sells the property themselves. If you sell the home for $8 million, you are responsible for the profit over and above the adjusted basis.
There are some situations in which it may be advantageous to create a true sale by dating the transaction more than a year after the divorce. Doing so will allow the spouse who receives the assets to receive a stepped-up cost basis which could provide significant savings for them in the future when they go to sell the property.
Taxation of Income
Just as the recipient spouse owns and is responsible for an increase in the basis of an asset that occurs after divorce, they also are responsible for income from the property. Once the court distributes a property, the spouse who becomes the owner becomes responsible for all taxes on any income the property produces, such as a commercial building with leases.
Distribution of retirement assets is a critical part of your equitable distribution and a significant part of your future financial planning. For some types of retirement accounts, a Qualified Domestic Relations Order (“QDRO”) must be created and accepted by the plan and the court for the asset to be distributed. QDROs are not necessary with IRAs. Instead, it is possible to institute a trustee to trustee transfer incident to divorce.
When retirement assets are distributed in a divorce, they are not taxed. The exception to this rule is that they are taxed if the funds are distributed and not rolled over. Because of this, your financial team must have a plan in place for rolling retirement assets into the appropriate account to avoid distribution. If distributions are the result, the recipient spouse is financially liable to the IRS for taxes and penalties and the transferring spouse has no liability.
Your divorce likely includes interstate and foreign assets. The layering of other states' and countries' laws makes the case even more complex. In addition to IRS rules, the property must comply with the laws of those states or countries. The U.S. maintains tax treaties with some other countries to reduce double taxation. U.S. foreign transfer tax credits can also be useful in this situation. When foreign assets are involved in a divorce, your attorney should work with experts in those countries' laws. It may also be useful for you to engage a trusts and estates attorney to manage your assets via trusts.
Laws have recently changed concerning alimony or spousal support payments and taxation. Previously, alimony was tax-deductible for the spouse paying it and taxable income for the spouse receiving it. The Tax Cuts and Jobs Act (“TCJA”) changed the law so that alimony is no longer tax deductible for the person paying it or taxable for the person receiving it. In essence, this law has now made alimony more expensive to pay since it is paid with after-tax dollars, placing the tax burden for the funds on the paying spouse.
To obtain a tax benefit in the face of this new law, illiquid assets are placed in a grantor trust, with the trust income paid to the former spouse who is receiving alimony. The spouse who puts the assets in the trust is not taxed on the income of the trust, while the recipient spouse is taxed on the income.
The recipient spouse may be displeased at having to pay tax on the income. However, the trust offers a benefit that regular alimony cannot: it continues after the death of the grantor spouse. Regular alimony ends upon the death of either spouse, so this provides the recipient spouse with an ongoing income despite the death of the paying spouse.
Note that child support payments are not tax-deductible for the paying spouse or taxable income for the recipient spouse, and that does not change even if child support is paid via a trust.
Taxation can significantly impact the true value of an asset. Your attorney will present an argument to the court that will maximize your tax benefits and ensure that you retain as much value and as little liability as possible.